As leaves in the Washington area fade from green to darker colors of fall, investors are also watching a gradual turn in the economy and wondering what’s next for markets. The S&P 500 declined 3% in the third quarter, and signs of a looming recession are growing. Meanwhile, a fully employed workforce continues to support the economy through steady consumption. The signals are mixed, to say the least, creating a tug-of-war-like tension between recession and resiliency.

This client letter will explore both sides of the slow-down versus soft-landing debate. Our current sense is that a recession is becoming increasingly likely. Still, by investing in companies with durable growth prospects, client portfolios can benefit from a sustained recovery on the other side of an economic slowdown.

What could go wrong?

Our main concerns with the economy include the Federal Reserve, the bond market, and manufacturing activity. Jay Powell and the Fed have been fighting a blitzkrieg against stubbornly high inflation by raising interest rates during the last 18 months. Higher rates, in theory, should slow the economy and rampant price increases. However, this slowing process frequently leads to recession.

Historically, economies tend to feel the heat of Fed tightening action about two years after the rate hikes begin. If this pattern persists, we should expect to see a recession in 2024. A silver lining for investors in this environment is that we now have an opportunity to “lock in” attractive rates of return on bond portfolios.

Speaking of rates, the bond market is also signaling caution because short-term bond yields are higher than long-term rates; typically, short-term investments would yield lower rates than long-term investments, giving incentive to investors to commit their funds for a longer period of time. This upside-down bond market could be a sign that growth and inflation are poised to creep lower and that a recession is looming.

Fed tightening and higher rates appear to be weighing on business expenses and spooking demand forecasts, as evidenced in more pessimistic manufacturing surveys. While the U.S. economy has a large exposure to services, we tend to watch manufacturing data as well, which historically has been a strong signal for demand and growth expectations.

Outside of these significant recession risks, we also see more temporary factors that could weigh on near-term economic growth including student loan repayments, rising gas prices, and a potential government shutdown. We view these as more fleeting risks, as the number of students paying back loans represents a relatively limited portion of the consumer base. And, while gas prices are up, we are seeing much less pain at the pump in 2023 compared to last year. Regarding Washington D.C.—well, who knows? But typically, we see that political strife results in only temporary effects on markets.

Can the economy power through?

While many signs in the economy are currently leaning towards recession, we are also seeing hints that the current level of modest economic growth can continue for some time. Gas has gotten more expensive in recent weeks, but overall inflation is dramatically lower now (in the 3-4% range), compared to a high of 9% in June 2022.

In addition to lower inflation, workers are benefiting from a tight job market and high demand from employers, resulting in stable incomes and purchasing power. A fully employed workforce and falling inflation seem to be supporting steady consumption: Retail sales have grown nearly every month this year. A happy consumer may help to delay a recession or bring about a “soft landing.”

Investing through the cycle

We hope that the economy will continue to grow, but our sense is the overwhelming weight of Fed rate hikes will more than offset durable consumer demand in the coming quarters and trigger some kind of slowdown. Supporting this recessionary view, Jay Powell expressed a higher-for-longer approach to interest rate policy during a September Fed meeting.

A pending recession could weigh on corporate earnings and keep stock prices under pressure next year, leading some investors to consider a defensive move away from equities before a recession. However, our investment process includes a focus on owning companies that can weather the business cycle and generally come out stronger on the other side as the economy recovers. We favor a more consistent approach to market-timing, which requires two good decisions—getting out and getting back in at the “right time.”

As we start to wrap up 2023 and look ahead to next year, we continue to evaluate both the risks of a recession and the potential upside of a resilient economy and earnings growth. Putting these near-term scenarios in perspective, we maintain our commitment to our core investment principles, which include a flexible, yet consistent approach to uncovering opportunities, remaining ever mindful of your long-term goals and objectives.

We wish you all a joyful autumn.

Michael Bailey, CFA
Director of Research

Michael Mussio, CFA, CFP®
President